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Convertible Note Terms: How Convertible Notes Work - YouTube
Channel: StartupSOS
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Convertible note is a very common
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early investment vehicle used for
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startup funding.
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Today we'll talk about the typical
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terms you'll see in a convertible
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note and at the end of the video
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we'll talk about some of the
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advantages and the drawbacks
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of using convertible note financing.
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Hi I'm Steve Morris and I use this
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StartupSOS channel to provide
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practical how to advice for
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first time entrepreneurs.
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So a convertible note what
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is a convertible note.
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Well it really is simply a
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loan that an investor provides
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to a startup.
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It's a loan that's made with the
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intent that it is not
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going to be paid back but with the
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intent that in the future
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it will convert to ownership in the
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company. Typically it'll convert
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into stock in a C corp.
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There are some financial terms.
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There are some conversion terms
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that determine how and when it gets
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converted to ownership.
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And there are some investor rights
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very commonly.
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And then a few miscellaneous other
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terms we'll go over.
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So let's start with the financial
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terms. Of course it begins with
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the financing amount - how much is
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being loaned.
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Second would be the closing date.
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When will this close and the money
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actually be provided to the
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entrepreneur.
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A third would be the maturity
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date. Very important term.
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When does the loan come due.
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Now that typically might be a year
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maybe a year and a half.
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Some cases perhaps as long as two
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years - you rarely see one that's
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any longer than that.
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The maturity date becomes pretty
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important as we'll get to in
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the next topic of conversion.
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And finally there'll be an interest
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rate. This is a loan.
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So not only a maturity date but
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an interest.
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It's usually a simple interest rate.
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8 percent is is very very
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common.
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But this is not an interest that
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you're actually paying it's simply
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an interest that accrues along
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with the principal of the loan.
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So that in the future it's
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the loan amount with interest that's
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going to convert to ownership in
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the company.
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It's not cash that you're typically
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going to actually pay to
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the investor.
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The next category of terms would be
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the conversion terms that determine
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when and how the loan amount
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converts into ownership in
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the company.
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Now the first option and in
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a way the desired one is the
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automatic conversion.
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Automatic conversion happens when
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in the future there's a priced
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round in other words an equity round
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where investors put a value on your
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company which determines a value
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- a price - on your stock and
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they buy stock in your
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company to make an investment.
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When that happens at some
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trigger amount that
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is what triggers the conversion.
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Now doing a future convertible note
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will not trigger a conversion.
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It's not an equity round
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it's only an equity round that will
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trigger it and it will
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be triggered by some particular
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amount like maybe a half a million
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dollar investment would be a common
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trigger. So in the future when
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there's an equity investment for
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half a million dollars the loan
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would typically then convert to
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ownership to stock with the same
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benefits the same terms
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that are negotiated by the future
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investors.
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Okay except for the price
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the price will be a little bit
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better for the note
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in terms of what they pay for the
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stock and that's reasonable because
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the note holder provided you money
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earlier when it was more risky.
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So it's it's reasonable
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that that money convert into stock
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with a little bit better deal than
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those future investors are
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going to get.
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Okay. So what determines the price
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that the note converts at.
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Well it's two terms that come to
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play here. There will be a discount
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and there will be a cap and
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the price at which
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the stock price at which the note
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converts depends on which two of
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those gives the note
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holder the better deal.
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So let's talk about the two examples
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using some some actual numbers.
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Let's say in the future
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you have an investment round - some
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investors give you a five million
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dollar valuation and to keep the
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numbers easy let's say you have five
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million shares of stock.
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Well OK stock price is easy to
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calculate then 5 million shares 5
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million dollars.
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It's a buck per share.
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Now if I have a convertible note
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let's say the convertible note was
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a five hundred thousand dollar
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trigger on the on the automatic
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conversion and this future round is
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more than that so it's going to
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trigger it and let's say it has a 20
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percent discount and a three
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million dollar cap.
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OK so a 20 percent discount.
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The dollar a share price
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is what's going to be paid by the
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future investors.
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20 percent discount on that is 80
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cents.
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So under the discount term
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80 cents is is what
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the note will convert at - the note
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will pay 80 cents per share for
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stock. Now how about the cap.
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What the cap means is that
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if in that future round
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you get a valuation above the cap
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then the price the note
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gets for stock won't
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be determined by that future
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valuation - it'll be determined by
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the cap. In other words the three
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million valuation in this
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example not the 5 million.
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So let's do the math again.
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A three million dollar valuation
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cap with five million
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shares of stock outstanding.
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Do the math on that and it's 60
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cents a share.
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So if I use my discount term
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I get 80 cents per share.
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If I use my cap term
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I get 60 cents a share.
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So of course I'll go with the 60
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cents and pay 60
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cents per share.
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So that's how my
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loan amount will convert
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into stock.
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So that's the basic idea of
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discount versus
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the cap and how you determine
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the price at which your loan
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is going to convert into stock.
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Now the second possibility is the
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optional conversion.
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Optional conversion is
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something that comes into play when
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you reach the maturity date.
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You reach the end of the loan and
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there has not been an
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equity investment.
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Well into the loan, the
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investor has three options.
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Basically they could call the loan
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but that's typically not going to
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happen unless things are going
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really badly because you probably
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won't have the money to pay it back
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anyway. And so the investor
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isn't likely going to do that
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again unless things are going very
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poorly.
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Another option is to extend
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the loan and there will be a
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negotiation in that situation
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and probably the investor will want
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to get some better terms because
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they're having to wait even longer.
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A third option would be this
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optional conversion where written
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into the note there will be
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already a predetermined valuation
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- a million dollars let's say would
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be very common - and it will say
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the money will convert
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into ownership into stock
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at that val uation of
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a million dollars or again whatever
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is written into the note.
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Now the amount will be a relatively
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small amount in terms of the
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valuation because the expectation is
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if you reached the maturity date and
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didn't have an equity investment.
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Things aren't going well.
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The the investor still wants
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to have stock in the company still
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sees the potential.
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So they want to go ahead and convert
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but they want to get a pretty good
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price because the company isn't
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making headway as fast as
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expected.
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So that's the situation
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for the optional conversion.
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So there is one other scenario to
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cover and that is what happens if
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your company gets bought before
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the maturity date of the loan and
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before there is an equity investment
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that makes it convert to stock.
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Well very commonly in
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that scenario you'll see a term that
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says that the investor
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the note holder gets paid
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to 2x - 2x of the note
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value plus 2x of the
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interest that's accrued
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since the note was provided.
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So that's a very very common term
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you'll see in the case
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of an acquisition that happened
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earlier than expected.
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Another category of terms that
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you'll often see are investor rights
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terms. Now those can include things
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like information rights maybe the
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investors have the right to get
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quarterly financial statements maybe
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a quarterly update from
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the management team.
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Those are certainly very common.
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Another set of rights that are
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common would be approval rights
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where the investors get the right to
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approve. In other words a veto power
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over important financial
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decisions - maybe over
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an acquisition somebody offers to
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buy you. They may get a veto.
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Maybe if you want to make a major
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change to your corporate documents
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you know maybe the investors get
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to veto that if if they're not
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happy. So those kind of control
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rights are not uncommon.
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Another common right for a large
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investor in a convertible note round
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might be board observer rights where
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the investor gets a board seat
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not a voting board seat but
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an observer seat so they get to
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participate in board meetings
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even though they don't get a vote.
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Another very common investor right
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that you'll see written in is pro
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rata participation rights.
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Now what that means is
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the note is going to convert
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in the future to stock in an
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equity round. Let's call that these
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series A the pro-rata
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rights say that
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the investors whose whose stock
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converted have the right in
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future rounds.
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Let's say the series B in Series C
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and so forth to
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invest more to maintain
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their their percentage of ownership.
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So for example let's say when
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the convertible note converts
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my note ends
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up owning 1 percent of the stock in
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the company in the series a.
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Well then in the series B I have a
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right to invest alongside
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the new investors for the series B
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enough money to maintain my
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percentage ownership in the company
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and again for the Series C and
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so forth.
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So it gives investors
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of the note an option
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to maintain their percentage
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ownership in the company.
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Those are the investor right terms
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that are common. Let's get into some
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general other types of terms that
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you can see.
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One would be a
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most favored nation clause
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that basically means that
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if you provide subsequent
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to the note let's say you provide me
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you provide a note to
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another investor that has better
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terms than the note that you gave to
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me. Then I have the right
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to adopt those better terms
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into my note retroactively
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so for example if there's a lower
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cap or a steeper
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discount a higher interest
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rate I would get the option
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of adopting those better
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terms from that other note.
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So again that is actually a
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pretty common term that you'll see.
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Another term you may have something
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in the documents about use of funds
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that perhaps say something like the
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funds are to be used for the
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operation of the company.
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And of course they can be more
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specific than that in terms of
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limiting what the funds can be used
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for and cannot be used for.
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A convertible note will almost
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always have a term that says
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prepayment of the note to pay
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it off is not allowed.
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And the reason of course is that
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the investor is providing you with
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that loan not with the intent that
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you'll pay it off but with the
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intent that it will convert.
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So you're not allowed to
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simply pay off the loan
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unless the investor agrees
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with that.
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Another very common term you'll see
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is if you're getting a convertible
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note investment as an LLC
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that's fine.
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That's not a problem but it may
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well say that in the future.
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Okay. When you get the equity
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investment round and the note
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converts to ownership at that point
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there's a requirement that you
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convert your company from an LLC
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to a C corp
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and that has to do with concerns
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investors typically have about flow
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through profit from an LLC.
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That's not an issue when you just
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have a loan but it is an issue when
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you sell a portion of the company.
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Now that usually isn't
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an issue because typically when you
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have that equity investment in the
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future typically those
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investors are going to require
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that you come a C corp.
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So this generally is not
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a big deal. It'll happen anyway.
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So those are the main terms that
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you'll see in your typical
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convertible note.
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Few words on the advantages
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of the convertible note and the
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disadvantages.
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On the advantaged side.
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One big advantage to the
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entrepreneur is a convertible
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note provides you with funding
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and it puts off, it delays
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a valuation of your company.
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Well that's a good thing.
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You get money to operate with
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and you push off your valuation
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until later when you're hopefully
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worth more money because
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you've made more headway
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so that convertible note then
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will convert into less stock
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because you're worth more
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so the price of your stock is
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higher.
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So that's a good thing for
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the entrepreneur.
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Your dilution is less.
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The other advantage of the
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convertible note compared to a
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priced round is that
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a convertible note is really a
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pretty small set of documents.
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It's typically a note agreement.
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The actual promissory note itself
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and and typically an accredited
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investor questionnaire where the
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investor verifies that yes they
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are an accredited investor.
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Those are pretty small pretty simple
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documents generally which means the
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legal expense is pretty small.
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To do an equity investment round
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involves many more documents
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much longer documents and
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in other words it gets a lot more
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expensive because there are so many
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more things to negotiate in the
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terms and you're typically paying
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legal fees every time you negotiate
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those things. So a convertible note
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saves you a lot of money
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versus doing a price round
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so it's another reason why you see
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them very very commonly
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in smaller early stage
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investments.
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Now there is a key drawback
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to a convertible note and that is
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that it has a maturity date.
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It comes due.
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There comes a point where
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you're you're going to face either
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having the note called or having
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it renegotiated and extended
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or having it converted to stock at a
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very low valuation.
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So that's the drawback.
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Now that's one of the attractions
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of a SAFE - simple agreement
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for equity.
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We'll tackle that one in the next
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video. But that's a disadvantage
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for the entrepreneur.
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It's an advantage for the investor
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because the investor often likes
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the idea that there's this date out
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there where if the company
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hasn't performed as expected by
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that date then the investor
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has a little bit of negotiating
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leverage to determine what
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happens next.
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So perhaps a good thing for
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the investor a little bit of a
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challenge for the entrepreneur.
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That is an overview of the
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convertible note the key terms
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and some of the pluses and minuses
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for the entrepreneur.
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If this was helpful Pplease click
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If you haven't there's a link down
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in the corner to do that.
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And after you've subscribed you can
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click on the bell to get notified of
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the next video because we'll have
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more coming up in this series.
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Next will be the SAFE.
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The simple agreement for
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equity. So I hope you'll join us for
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that one.
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That's it for now. Thank you very
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much for watching.
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